Question

Question 1

A company is considering drilling a development well. Wellsite preparation, drilling and testing of the well is expected to cost $2.2 million. Completion of the well and the field equipment necessary to get the well ready for production (wellhead, tubing, flowline, etc.) would cost $1.4 million. Company geologists have suggested that there is a 20% probability that the well will be dry. If that is the case, abandonment and reclamation costs would be $150,000. In the event the well is successful (80% probability), it is anticipated that it would have an initial production rate of 80 barrels/day with production declining by 17% per year and an economic life of 13 years. A $150,000 abandonment and reclamation cost would have to be incurred at the end of the well’s economic life. Operating costs are expected to be $250,000 per year. Oil prices in the first year of production are expected to be $70/barrel and are expected to rise by 2% annually thereafter. Given a marginal opportunity cost of investment for the company of 18%, use the expected monetary value (EMV) criterion to determine whether this well should be drilled. Assume all capital costs occur in the present period (time 0) and production and operating costs begin in year 1.

Question 2

With respect to the previous question, suppose that, after drilling, testing reveals that the initial production rate would be 40 barrels/day instead. If capital costs, abandonment/reclamation costs, initial prices, operating costs and growth/decline rates all remain the same, would the company complete the well ? Note that the well’s economic life under the assumptions used here would be 9 years.

Answer 1